An economic warning to the US dealer
It is now spring of 2011 and we are experiencing a thaw from one of the harshest winters on record. The temperatures are rising and the days are getting longer. We are also beginning to see green sprouts after a long two years of economic disaster, chaos and stagnation. There is, once again, true cause for optimism in the retail automotive industry. In spite of these encouraging times however, I believe that there are several macro-economic factors that should cause dealers to pause and take note.
One of these factors is the emergence of rising inflation. Over the past several years, the national debt has risen to an unprecedented level. Without the political will to dramatically increase taxes or cut spending, the Treasury Department’s only recourse has been to sell treasury notes (IOUs) to the Federal Reserve. The sale of and the purchase by the Federal Reserve of these treasury notes is called Quantitative Easing (QE).
When the Federal Reserve accepts the treasury notes, they go in the back room and fire up the printing presses to hand over currency to the Treasury Department in exchange for its notes. As a result, the amount of U.S. currency in circulation today is thought to be at historic high levels. In fact, the government has stopped reporting this money supply known as M3.
Today, with record amounts of currency pumped into the economy and the increasing velocity in which the currency is circulating, we’re beginning to see signs of inflation. Gasoline, raw materials and food costs are just a few staples that are at recent high levels. It should be further understood that the number one enemy of an economy is inflation and it is the Federal Reserve’s legislative mandate to preserve price stability by fighting inflation. The only means by which the Federal Reserve can flight inflation is through interest rate hikes. To this extent, I believe that rising interest rates are a certainty in the near future.
I personally lived and worked in the automobile business in the early 1980s when prime interest rates were as high as 21%. I don’t know if we’ll see interest rates that high again, but it’s not beyond the realm of possibility.
Over the past decade, automobile dealers have been lulled into a sense of security by cheap money and virtually no inflation. Certainly there have been recent times when credit has been unavailable or scarce and we all know the trauma that it caused dealers. Although credit is now available, soon it will become very expensive. The question is will the American automobile dealer be able to bear its cost?
Dealers need reasonably priced credit to support floor plans, revolving lines of credit, mortgages and equipment financing. At today’s cost of money, many dealerships are operating very close to break-even levels. What will happen if the cost of their capital doubles, triples or quadruples, outcomes that are well within the realm of possibility.
This risk is compounded by internal and external pressure on dealers. Internally, dealers have been hunkered down riding out the economic storm for the past two years. At the first sign of relief, the eternally optimistic dealer may now be ready to spread their wings by relaxing their fiscal conservatism. In addition, dealers are feeling external pressures from their manufacturers to purchase fledgling competitors and to remodel and in some cases, relocate their facilities. Arguments can be made that now is the time for dealers to reinvest in their businesses and future. This however, may in fact be exactly the wrong time to do so.
It is time to ask yourself what happens to your dealership’s profitability not if, but when interest rates rise. Now is the time for prudent operators to model their business pro forma with assumptions of 8, 10, 12 and possibly 16% prime rate adjustments. Remember that a rise in interest rates will not only increase operational costs at the dealership, but they will also certainly slow the pace of both new and used car sales. To this extent, your pro forma model should consider both circumstances.
When I recently explained these concerns to a highly respected industry colleague, he warned me that car dealers don’t like to receive bad news. I paused and thought for a moment and concluded that he was correct, but a fair warning is nevertheless in order. If it turns out that the fear of rising interest rates were unfounded, the risk to automobile dealers will have been minimal. Financial conservatism and the husbandry of cash are seldom, if ever imprudent. If however, this warning comes true, the advice may be vital to survival.